All that Glitters is not necessarily Gold

Gold has traditionally been a play on inflation or deflation.  However the price of gold has risen 15% in the past three months despite inflation expectations falling slightly and country default risks declining sharply.  The price of gold has done the opposite of what would have been expected.

The fall in real interest rates across the US yield curve has seen the US dollar decline in value.  We need to remember that gold is priced in US dollar terms.  Excess liquidity is also at an all time high and it could also rise if the Bank of Japan and the European Central Bank try to reduce the weakness of the US dollar.

Historically, the value of many currencies was backed by gold reserves.  This changed in the years following the Second World War.  The US dollar matters internationally because from the 1950s onwards it has served as the world’s leading reserve currency.  Its position in this role was enhanced when US President Richard Nixon ended gold convertibility of the greenback in 1971, effectively destroying the Bretton Woods system of currencies, whereby a country’s currency was backed by its gold reserves.

If we really go back in time to Roman days, we find that soldiers were paid in salt and even garlic.  Gold took over as it was much more durable, and easier to store.  More importantly it was then possible to mint money of differing values based on the weight of the coin.

A lot of people will remember the old James Bond Movie “Goldfinger”, where an attack on the US Gold reserves stored at Fort Knox was ultimately thwarted.  Gold is expensive to store securely, and it does not generate an income stream.

The price of gold tends to rise when the real (after inflation rate) US Fed rate is below 2%.  This is likely to remain below 2% for at least another year.  Because of this a number of analysts are predicting that gold could pass the $1100 an ounce mark.  Some hedge funds are betting that it could even exceed $1200 within a year.  Economies have changed somewhat over the past couple of years, and the reliability of old historical trends being good indicators of future events such as future gold prices must be seriously questioned.

We have two countries with massive populations and rapidly rising living standards, namely India and China who really value gold.  As their populations become more affluent, the demand for gold in the form of jewellery will grow strongly, possibly outstripping the supply of newly mined gold.  This in itself will impact on the price of gold, let alone its industrial use.

So how can investors participate in gold? A Google search will come up with a plethora of ways to buy gold.   The important thing to remember is that they will often be expensive ways, as those who are doing the selling will be making significant margins.  Investors can indirectly buy an exposure to gold buying shares in gold mining companies.  Again, this can be high risk investing and it may be better to be buying platinum.  Nearly half of platinum demand is automotive related.  If there is a strong recovery in the automotive industry, there would be more demand than supply.

We have seen time and time again that when investors try their hands at taking tilts to gold, or to say Europe or Asia or the BRIC countries, they achieve little more than increasing risk to their portfolios.